More Volatility Expected for October

Following Federal Reserve Chairman Jerome Powell’s speech on Tuesday, traders were anxiously awaiting any new progress reports on the next round of stimulus. Volatility is expected.

a yellow warning sign that says "volatility ahead"
Source: Shutterstock

We agree with the chairman that the economy is likely to struggle significantly without more fiscal stimulus, which will require the U.S. House of Representatives and the Senate to agree to a package that can be signed by President Trump.

Although everything is likely to continue changing quickly, President Trump’s direction to his team on Tuesday to stop stimulus negotiations with Congress until after the election puts quite a damper on the enthusiasm traders were feeling earlier this week.

At this point, we still consider progress on stimulus to be the most important X-factor facing the market and we aren’t ready to say it can’t happen in the short-term. Unfortunately, the volatility in Washington, D.C. will probably continue overshadowing third-quarter earnings, so for now, we will have to wait to see how this plays out.

This has put the focus on the election in a new way. We have been getting a lot of questions about the longer-term impact it is likely to have on the market and whether there are any short-term opportunities to profit.

Elections and Volatility in the Market

The challenge for most traders when considering how a presidential election may affect the stock market is to separate their political feelings from the data. Humans are tribal by nature, and that seems particularly true to us currently as everyone “picks a side.”

However, like most aspects of investor psychology, if we know that there is a tendency for investors to behave emotionally, then we have an edge.

If investors react in ways that do not match our historical data, then the market is likely overbought or oversold, and we can take advantage of the eventual “return to the mean.”

We should still plan to proceed with caution because the data we have about election-related market returns isn’t ideal. It is hard to isolate the specific effects a president has on the economy compared to the 300 million people in the U.S. who work for businesses, make economic choices, and do the actual work in the economy.

There are usually two ways to think about the effect of a president’s administration on the stock market. The first is the presidential cycle, which has been fairly reliable at four-year terms. The second is to compare the returns of presidents of each major political party.

The Presidential Cycle

Since 1950, the third year of any given presidential term tends to be the best, and the fourth and first are the worst. President Trump’s term seems to be tracking along with the long-term averages so far. The average performance in the third year of a president’s term is 16.4%, versus 6.6% and 6.5%, for the first and fourth years, respectively.

Our theory is that this phenomenon reflects traders discounting uncertainty just before and after the election and then removing that discount once they feel more confident about a president’s policies and likely future actions. The political party of the incumbent or incoming president doesn’t make a big difference for market outcomes.

In fact, on average, the market returns of a full four-year term are 8.6% and 8.8% for Republican and Democratic administrations, respectively.

This year is clearly different in the sense that investors are dealing with the unknowns of the election, the Covid-19 pandemic, and extreme economic disruptions at the same time. This makes it harder to apply long-term averages to the market, but since the market is only up 4% this year, we don’t see any reason to assume it is automatically over-extended — yet.

Returns by Party

Depending on the preference of the investors we are talking to, we often get surprised reactions to the returns by party data.

However, before we go into that, we should discuss the issue of correlation vs. causation. It seems very unlikely to most economists, that the president (or their party) has very much influence over the actual returns of the market. Although we are sure they wish that they did.

In the table below you can see some examples of the best and worst terms just to see how diverse those extremes are by president and party.

A chart showing the best and worse stock market returns during presidential first and second terms.
Source: Chart by InvestorPlace

This illustration is not to make a case in favor of Biden or Trump. Instead, we hope you found the data somewhat surprising. Most investors tend to make bad estimates about the president’s party and market returns and that leads them to make bad assumptions about the market following elections.

The best recent example we have of this is the night President Trump won the election in 2016. The Dow Jones Index futures dropped 750 points.

Investors oversold the outcome. The market reversed, which gave bulls a great short-term opportunity. This is not a unique issue to the 2016 election. It’s actually very common and that gives us an edge.

Daily Chart of S&P 500 Futures During the 2016 Election, from June 2016 to the following April.
Source: Daily Chart of S&P 500 Futures During the 2016 Election — Chart Source: TradingView

If President Trump is re-elected or former Vice President Joe Biden is elected, traders are likely going to overreact one way or the other, increasing volatility. If that volatility happens, we should take advantage of that overreaction by investing in the opposite direction.

The overreaction is most likely based on the tendency for traders to “sell the news” and overshoot a correction. The historical data seems to point towards a likely positive outcome regardless of which party controls the White House.

We suspect that we may get some feedback from readers about the dire consequences of a “socialist, liar, swamp-dwelling career politician, bankrupt mogul, etc.” being elected (or re-elected).

We have heard the same thing for each election and we will continue to bet on Americans to use innovation, industry, cooperation and hard work to continue pushing the economy forward regardless of who wins. So far, putting our faith in the American people has played out well.

The Bottom Line

This week’s update was a lengthy discussion about how elections tend to have a moderate long-term impact on market volatility, but also create interesting short-term profit opportunities when traders overreact. We will keep you updated on our plans to take advantage of that as election day nears.

In the meantime, we suggest not abandoning all hope for a stimulus bill to pass. If the market drops for a few days, it will give us another chance to sell puts on the dips and it will likely put pressure on the folks in D.C. to get a deal done. Adding to the pressure will be earnings, which start to stream in next week. So far, the results look likely to be down compared to last year, but better than average expectations.

On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article. 

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities. 

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